Massive Stimulus May Boost Inflation the Wrong Way: Stagflation

By Daniel Lacalle
Daniel Lacalle
Daniel Lacalle
Daniel Lacalle, Ph.D., is chief economist at hedge fund Tressis and author of “Freedom or Equality,” “Escape from the Central Bank Trap,” and “Life in the Financial Markets.”
April 13, 2020Updated: April 16, 2020


All over the world, governments and central banks are addressing the pandemic crisis with three main sets of measures:

  • Massive liquidity injections and rate cuts to support markets and credit.
  • Unprecedented fiscal programs aimed at providing loans and grants for the real economy.
  • Large public spending programs, fundamentally in current spending and relief measures.

However, as well-intentioned as these measures may be, they may cause deeper problems than they aim to solve. When governments try to artificially boost debt and demand in a supply shock, the risk is to create a massive deflationary spiral driven by debt saturation that’s followed by stagflation when supply chains start to be insufficiently flexible.

This is a health crisis and a supply shock added to the forced shutdown of the economy. As such, policies aimed at boosting demand have very little effect because whatever demand is artificially created won’t be followed by supply, as long as the economy remains shut.

Considering that the opening of the economy will be gradual and subject to changes, it may be safe to say that the risk of achieving little positive impact with these stimulus packages is high.

Governments make two important mistakes in a lockdown as severe as this one: thinking that the impact is similar in all sectors, and believing that a nationwide shutdown will be recovered from swiftly.

There are sectors that will take years to recover: travel and leisure, autos, retail, fashion, music, cinema, tourism, and energy all face years of weak demand, balance sheet reparation, and survival-mode strategies.

The collapse in earnings and cash flow, followed by the more-than-likely tax hikes we will see, are also going to create an enormous burden on research and development, innovation, and technology.

The financial sector was already weak in 2019, suffering from negative rates, high non-performing loans, and weak return on tangible assets. The impact of the crisis will be severe on existing assets, with rising non-performing loans and downgrades of earnings.

If we add to this that most governments’ stimulus packages are based on approving massive loans for companies that may face years of difficulties, the strain on banks is going to be significant, and may lead to a financial crisis after a supply shock.

The key measures to take in a supply shock with a forced lockdown need to be supply-side measures, eliminating taxes throughout the lockdown, reducing unnecessary expenditure to accommodate for higher health care costs, and providing non-recourse liquidity lines to preserve the business fabric, as well as giving sanitary equipment and protocols for businesses to manage the supply chains.

Some governments, such as the U.S. administration, are combining both demand and supply-side measures. Others, like most of the large eurozone economies except maybe Germany, are only focused on policies driven to provide credit relief and increased spending.

With these measures in mind, and considering the slump in economic activity, corporate profits, wages, and tax revenues that will be generated, global debt is likely to soar above 350 percent of GDP.

This means that the vast majority of the stimulus packages will be aimed at financing higher debt created by government non-economic-return current spending and hibernating large companies, while small and medium enterprises, which have little access to debt and maybe no assets to leverage, simply disappear. Start-ups and small businesses may face a double negative of zero access to equity as well as a collapse in sales.

When governments and central banks announce massive stimulus packages at the very beginning of a crisis, they bet on a speedy recovery and a return to normal as if nothing had happened. This is far from the case today. Debt-fueled stimulus into a lengthy and painful recovery may generate a deflationary spiral in the short term that likely will be addressed with more monetary and fiscal stimulus and then will create stagflation.

The evidence shows that the global economy has recovered in a much slower and indebted way from each of the past crises. However, none of the crises of the past 50 years have been remotely similar to this one. We’ve never witnessed a global shutdown of the entire economy, and policymakers have no idea about the mid- and long-term ramifications, so doubling-down on debt and liquidity is, at the least, dangerous.

How do we go from crisis to deflation and then to stagflation?

The process would be the following:

  • The crisis is created by the pandemic and the subsequent closing of entire economies in a domino effect, causing strains on supply chains as well as a domino of credit events in highly indebted sectors.
  • Governments bail out the large and strategic sectors as well as citizens with massive loans, grants, and fiscal measures but leave behind the preservation of supply chains at a global level. As the crisis deepens and lasts longer, governments decide to take protectionist and interventionist measures that further erode supply chains. This period is deflationary because money velocity collapses, investment stops, consumption is weaker, and citizens try to hold on to the little savings they have.
  • The deflationary and indebted spiral is addressed with more liquidity and more debt, but by now, the supply chains have been irreparably damaged, and interventionist measures add to rising inflation in essential goods and services. The economy remains in stagnation, but prices creep up.

I genuinely hope that this won’t happen. I will be delighted to be wrong.

The pandemic lockdown is showing us the importance of having open supply chains, diversified, global, and efficient companies, as well as competitive services. It also shows the importance of collaboration.

The solution to this crisis must be global and local at the same time. The global answer should ensure that cooperation and trade are preserved and that liquidity policies are also aimed at emerging economies, not only developed ones. The local answer must be aimed at ensuring a rapid recovery of the lost jobs by preserving the business fabric and ensuring that companies have the equipment and protocols to come out stronger.

Interventionism will only lead to stagflation.

Daniel Lacalle, Ph.D., is chief economist at hedge fund Tressis and author of “Freedom or Equality,” “Escape from the Central Bank Trap,” and “Life in the Financial Markets.”

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.