Governments Should Do More To Curb Inflation And AI Will Help

Are governments doing enough to curb inflation? Thus far, we avoided the stagflation scenario of the 1970s and ’80s. But, despite inflation trending down, it is still at levels far above the desired 2% in Europe and the US.

What do authorities do to curb inflation? And are they doing enough without plunging us all in a deep banking crisis 2.0 or a severe recession?

Breaking banks is deflationary

The central banks are quickly tightening monetary policies by raising interest rates to increase borrowing costs, to slow down spending and the money supply. Also by reversing quantitative easing, called quantitative tapering, central banks are reducing the money supply on the financial markets. However, when interest rates hike quickly, something will break. In this case, SVB and a number of other banks. The bank failures lead to the disappearance of financial values – bank CoCos, shares and bonds loosing their value. This is deflationary. On the other hand, to save deposit holders, central banks provided daily liquidity to stafe off bank runs. This is – at least temporarily – increasing money supply. Therefore, central banks continue to signal their anti-inflationary intentions by further increasing interest rates.

Governments still spend too much

But, what sense does it make if central banks are reducing money supply, while governments are still in a crazy spending mode after the COVID-19 pandemic? During high inflation, it is better to put a break on government spending. Governments should cut down on budget deficits, to reduce demand in the economy and thus help to bring down inflation. Over time, higher borrowing costs will push governments to do so. But, it is far better if they are more proactive in this. It will help us more quickly into the inflationary green zone, and prevent our hard earned savings to melt away.

Curb obscene profits

If high demand is the cause of inflation, a government could also decide to increase taxes. But, as the causes of the current inflation are supply related this doesn’t make a lot of sense. Disrupted supply chains due to COVID-19 and the Russian invasion that led to price hikes in energy and certain goods. Energy prices are quickly coming down to pre-war levels as supply gets more diversified and abundant. Investments in solar and wind power and batteries for power storage pay off. In stead of increasing taxes to reduce disposable income, it is better to focus on fixing all critical supply-side issues.

Energy source diversification, becoming less dependent on Russian oil and gas, and introducing a price ceiling, have already come a long way. Also, the COVID-19 related supply shocks due to lockdowns in China are gradually overcome. At the same time, the war incentified governments to spend more on weapons and related goods and services to help Ukraine. Western governments are now encouraging investment in weapon production facilities to increase their production capacity. Therefore, improving efficiency is critical to reduce this new inflationary pressure.

Although the root causes of inflation seem to be more or less under control, we have now to deal with secondary effects. Manufacturers and energy companies seem to have taken advantage of the inflation scare to pump up profits by increasing their prices citing energy costs, but not adjusting them back when energy prices fell. Of course, worker unions are demanding compensation for the higher cost of living and companies are willing to pay as there are labor shortages. In case of obscene profits, governments can step in by regulate wages and prices to prevent them from rising too quickly, or by imposing a temporary profit tax. This can help keep inflation in check, but it can also lead to other economic problems, such as shortages, black markets and tax evasion.

AI-driven productivity leap

The sudden breakthrough of AI, seems to help already resolve the issue of labor shortages in the professional services market. A steep increase of AI-driven productivity might be the deflationary event of the century. But, it will take a while to become manifest on a macro-economic level. Many jobs in translation, editing, copy writing, graphic production, programming, management advice, customer support, financial control etc. etc. will be done with far less people. I noticed, for example, that AI could help me produce a press release in 15 rather than 60 minutes.

Such a productivity jump with a factor four would be massive and definitely curb inflation. Many white-collar workers could produce far more or better, or could shift to other jobs that are more valuable in the era of AI. Such productivity jumps typically lead to lower prices, higher quality of products and services and the invention of new categories of products and services. We are entering a wonderful – for some scary – deflationary era. But, still governments need to help fix the short term demand and supply issues.